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A Price Correction Is Unavoidable

Although loan defaults on commercial properties remain at low levels, the credit crunch in the real estate markets will still have some negative impact on commercial property values. In many instances, property values will decline because the lenders financing commercial property purchases will demand higher yields on their loans than they did when property prices soared between 1993 and 2006.

The federal government also is likely to impose new regulations limiting the degree of securitization that lenders can undertake and requiring much more transparency concerning what specific properties underlie each issuance of securitized paper. This column discusses why both these changes seem likely.

Ironically, the fundamental cause of the current credit crunch in real estate markets was a huge oversupply of capital trying to buy “desirable” properties. It started around 1993 and accelerated after the stock market crash of 2000. This financial capital came from a worldwide surplus of savings.

The second cause of the credit crunch was the collapse of the stock market in 2000 when the Internet bubble burst. Trillions of dollars, euros, yen and other currencies fled from stocks and bonds and began pouring into real estate. This movement of money was aided by the third basic cause — increased ability to move capital around the globe almost instantaneously thanks to computers, satellites, the Internet, and securitization.

Tons of money was suddenly focused on trying to buy real estate that offered attractive yields and prospects. The world demand for quality properties vastly exceeded the available supply, causing intense competition among owners of capital to purchase the best available properties, or to make loans enabling others to make such purchases.

Market overheats

Whenever there is a lot more money-backed demand than supply for a product such as real estate that can't be produced quickly, two things normally happen. First, competition drives prices up and capitalization rates down. Second, the same competition motivates capital suppliers to reduce their underwriting standards in ways that increase the risk of potential default and other problems.

That happened not only to property buyers, but also to the capital suppliers. As property prices rose, the interest rates that lenders could collect fell. And as competition among those lenders intensified, they too reduced their loan covenants in order to stay competitive in a world over-supplied with capital.

By 2005 and 2006, lenders and buyers were not being properly compensated for the risks inherent in their purchases as evidenced by the historically low yields they were willing to accept.

Problems encountered by subprime mortgage lenders brought the risk-reward gap to light. As more borrowers began defaulting on subprime loans, it became apparent to single-family and commercial lenders that they needed to raise the interest rates they were charging to obtain adequate compensation for risks of default, or even foreclosure.

When buyers were forced to pay higher interest rates and meet tougher loan terms, they couldn't get enough loan proceeds to pay the high prices that property sellers were receiving. In short, recognition of the true costs of the risks that capital suppliers had been taking required a decline in prices of both residential and commercial properties.

Sellers to lose some gains

Price declines will not occur as rapidly in commercial real estate as in housing. Most commercial owners are not under pressure to sell in the near term, unless the economy gets so weak that their net operating income falls sharply.

Many commercial property owners will not accept the idea that the prices of their properties must fall. First, there must be an extensive period in which hardly any sales occur, except for a few made at higher cap rates and lower prices. This holdout attitude will prolong the period in which credit is difficult to obtain in commercial property markets.

If most commercial property owners who have made huge profits from big price increases over the last decade do not eventually recognize the need to give back at least some of those gains, deal volume will remain far below recent records for a long time.

Another reason commercial property prices are likely to decline is that the amount of money seeking to invest in the asset class needs to drop far below the level of investment between 2000 and early 2007. Too much money seeking too few properties during that period exaggerated pricing levels.

The real estate market cycle swung from that surplus of capital seeking investments to the present acute shortage of capital suppliers willing to make investments because of uncertainty over values. We need to return to some intermediate position, which can only be reached if many more property owners are willing to accept lower valuations than they now believe are appropriate.

Quantifying the correction

How far will commercial property prices fall? No one can be sure, but consider how much those prices rose from 1993 to 2006. If the net income from a commercial property remained the same in dollars from 1993 to 2006, the prices of properties rose an average of 63.9% among industrial properties and 78.3% among office properties.

Those figures are based solely on declines in the cap rates typical of such properties, according to the National Council of Real Estate Investment Fiduciaries. But if net operating income rose by 20% during the same period, the price increases reached 96.7% and 113%, respectively. There is plenty of room for property prices to decline and still leave owners financially well off, if they owned the properties throughout that period.

Increased government regulation is the second impact of the credit crunch. Financial operators who are not under any strong oversight, such as many mortgage lenders and bankers and conduits, will become more constrained by regulations limiting the terms under which they can make loans. That's especially true of subprime mortgage lenders.

Home loans that require no down payment should be restricted to borrowers who can pass financial capacity tests, or even prohibited completely. Loans based on a borrower's statement of income without proof should be banned. Tighter limits should be placed on the share of total income that homebuyers could use to make mortgage payments.

As for financial derivatives, the ability of parties creating credit default swaps and other similar instruments to assign their financial responsibilities to other parties without consent, or even knowledge of their original counterparties, should be reconsidered and perhaps prohibited. Parties providing insurance against risks of default should be required to provide evidence of ability to pay in case default occurs before completing such insurance deals.

Issuers of securitizations based upon pools containing pieces of multiple other securitizations should be strongly constrained or required to provide clarity on what properties those pools actually contain. This likely increase in regulation reflects recent experiences in which many suppliers of capital had no clear idea of what they were investing in exactly and suffered the consequences.

Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at [email protected].